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Risk and Return

The investment process is governed by the concept of risk and return. The phrase higher risk equals higher expected return. What does this mean?
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Welcome to Risk and Return

  • We often use the phrase higher risk equals higher expected return. What this means is that if we take on an investment that is riskier, more uncertain, then we expect that in the long run we will earn a higher return to compensate us for that risk.
  • This is not a guarantee, if we always earned higher returns then it wouldn’t be risky, but as a general principle we find that over time riskier investments tend to earn higher returns on average.
  • A common mistake people make however is taking on riskier investments without being adequately compensated for them.
  • But why do people take uncompensated risk? One possibility is that people do not fully understand the risk they are taking.
  • But what do we mean by these terms? Risk is an interesting term that in finance has a different meaning then we are commonly familiar with. Understanding what returns are, what risk actually means and the simple but important relationship between the two is key to understanding when an investment is worth making.

RETURNS

What are returns?

  • These are the payoff we get for investing in something.
  • The type and nature of the returns differs for different types of investments i.e. Bank deposit, Corporate Bonds, Shares, Property, and Cryptocurrencies and Foreign Exchange

How do we measure returns?

  • In general we measure returns as the percentage change in investment value. We need to include all the payouts we receive along the way. Also need to consider the change in the value of the investment.
  • Can calculate returns as ((Current Value – Initial Value) + any payouts)/Initial Value. It gives us a percentage return for our investment.
  • Percentage returns tell use total return since we bought the investment, how do we compare between investments bought at different times, how can I adjust my returns for time?
  • Capital vs Gross Returns. If we just focus on change in prices/value we are calculating capital returns. By including other payouts we are calculating Gross returns.
  • Why does it matter? We see big differences in the source of returns, particular for some stocks such as old well established companies and Young start ups.

RISK

What is risk?

  • We often perceive risk as a negative – something to avoid
  • In investing, risk is neither a negative or a positive
  • We define risk as uncertainty regarding returns. Some investments have very certain returns i.e. bank deposits. Others are much less clear i.e. shares
  • The uncertainty runs both ways. Our eventual returns could be very negative, or they could be very positive.

How do we measure risk?

  • A key measure that we use to measure risk is standard deviation
  • This is a symmetrical model – positive surprises are as likely as negative surprises

How do We Measure Risk

  • How do we interpret the standard deviation? What if Microsoft Corporation (MSFT) had an expected return for the next year of 12% and a standard deviation of 15%? 66% of the time (2 out of 3 years) you would expect MSFT to return between -3% (12%-15%) and 27%
  • In comparison, if we put our money into short term government bills (government debt that is assumed to be riskless) at 1% we will earn 1% next year.
  • MSFT is riskier, but that offers us the possibility to earn much greater returns. Some years will be positive and some negative. Over a long period you expect that MSFT will offer a much better return. But nothing is guaranteed

Application to Investment

  • Having discussed what risk and returns are, how does this play out in the investment space?
  • As we discussed earlier, in finance we argue that over time riskier investments will pay higher returns. This means that if I want to earn more, I need to invest in assets with more uncertain outcomes. And over extended periods of time we typically see this holds true.
  • Let’s consider the period from 1972 to 2020 and look at investing in either cash, US short term government bills, US corporate bonds, US large company shares, or US small company shares, and you see that as the risk increases, so too does the average return. Short term government bills earned slightly more than cash, while corporate bonds earned more than government bills, while stock market investments earned more again.

Table – Period from 1972 to 2020

  Cash Short Term Govt Corporate Bonds US Large Cap US Small Cap
Return 4.73% 5.92% 8.85% 12.00% 13.90%
Std Dev 3.65% 4.88% 8.27% 17.22% 20.77%
  • Although the differences in returns do not seem huge, remember compound interest. $100 invested in 1972 would be worth $935 if we invested in cash, and $24,267 if we invested in US small cap stocks. Small differences add up!
  • But does it always hold that I earn more by investing in riskier assets? In shorter time periods, not always. In some periods of time recently, for instance 2000 to 2010, you would have been better investing in the bank then in the stock market.
  • This period was marked by two significant market crashes, the dotcom bubble in the early 2000’s and the Global Financial Crisis in 2008. However, over longer periods this relationship has held true.
  • One thing we do need to consider is whether we can reduce the risk of our investments without impacting the overall return.
  • There are strategies we can employ, and we will next discuss an incredibly important one, Diversification.

What is Diversification?

  • We often use the phrase don’t put all your eggs in one basket when we talk about Diversification.
  • The idea behind it is simple, instead of taking one big bet on a single asset that might either pay off big or fail spectacularly, we instead spread our investments across a range of assets.
  • The advantage of this approach is that if something goes wrong, and one of our investments fail, instead of losing everything we lose only a small portion of our investment.
  • Putting aside bankruptcy risk, we can also mitigate large price movements. Take stocks for instance, they often react differently to the same event.
  • Let’s consider the COVID pandemic. The lock downs instituted in most countries have had two main impacts. It has forced many people to work from home, promoting use of software like Zoom and Teams; and it has drastically reduced tourism meaning that less people are flying.
  • The impact is that we have seen companies enabling remote working to perform extremely well, at the start of 2020 Zoom was trading at around $USD 67 per share and peaked in peaked in October at $USD 559.
  • Had you owned Zoom shares you would have been VERY happy. Contrast this with an airline company like American Airlines, who was extremely negatively impacted by COVID. American Airlines started 2020 at around $USD 27 per share and bottomed out in May at around $USD9 per share. Had you only owned this stock you would have lost a lot.
  • Given that very few people can consistently pick winning stocks, most of us are better off spreading our money broadly rather than trying to pick winners. It is worth noting, even professional investors struggle to pick winners consistently!
  • Diversification means we don’t fully capture the big wins; it also means that we offset some of the big losses.
  • In the case of COVID, by holding both Zoom and US airlines we reduce the impact of COVID as the loses we make on US airlines is offset by the gains from Zoom. As the impact of COVID lessens and more people go back to their offices and start traveling we have seen the price of Zoom drop and US airlines rise.
  • Given the pandemic is difficult to fully anticipate, for instance the emergence of the Delta strain, there is a lot of risk in trying to ‘time’ when to buy and sell companies like Zoom and US airlines. Holding a well-diversified portfolio removes that risk by reducing the impacts of the downs.

How does Diversification work

How Does Diversification Work

  • Other aspects of Diversification
  • Diversification need not just be about different shares
  • Different asset classes behave differently i.e. when shares fall, bond prices tend to rise. Gold and shares are seen as negatively correlated i.e. move in opposite directions. Adding some gold to a portfolio can offset share market risk!
  • Different countries behave differently. For instance the Australian economy is heavily driven by resource prices. Germany in contrast exports manufactured goods like cars and appliances. When the Australian Stock Exchange is doing well, the German stock markets might not, or they might!
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